Economic prospects following Brexit are not reliable

Economic prospects following Brexit are not reliable

by Douglas Lowe
article from Friday 13, April, 2018

“GUNS OR BUTTER” used to be every undergraduate’s introduction to the economic analysis of the benefits of trade, but in Harvard’s Professor Mankiw’s Principles of Economics there is a more “fanciful” analogy: television commercials or grass mowing! 

In his analogy Tom Brady, an iconic American Football player earns $20,000 for a two hour TV commercial and, being supremely fit, can mow his own lawn in two hours. A college fan, Forrest Gump, can mow the same lawn in four hours at a cost of $40, his opportunity cost of not working at McDonalds for four hours.

In absolute time Tom Brady has an advantage: he takes only two hours, but Gump takes four and why, therefore, does Brady, who can do the mowing more quickly, hire Gump to mow? Brady’s opportunity cost, the cost of giving up the TV commercial is $20,000, but Gump’s opportunity cost of giving up McDonalds is $40, so if Brady pays Gump more than $40 and less than $20,000, both are better off!! A generous Brady likes the kid and pays $100, so Gump is $60 better off than working at McDonalds and Brady is $19,900 better off having done his TV commercial.

The economic advantage of trade, implicitly encompassing the principle of comparative advantage, was formally enunciated in 1776 by Adam Smith, “It is a maxim of every prudent master of a family, never to attempt to make at home what it will cost him more to make than to buy. The tailor does not attempt to make his own shoes, but buys them of the shoemaker. The shoemaker does not attempt to make his own clothes but employs a tailor. The farmer attempts to make neither the one nor the other, but employs those different artificers. All of them find it for their interest to employ their whole industry in a way in which they have some advantage over their neighbors, and to purchase with a part of its produce, or what is the same thing, with the price of part of it, whatever else they have occasion for.”

In 1817 David Ricardo demonstrated and expanded Adam Smith’s theory in the context of international trade. He considered an example with two goods (wine and cloth) and two countries (England and Portugal). He showed that both countries can gain by opening up trade and specialising, based on comparative advantage. Ricardo’s theory is the starting point of modern international economics and the central argument for free trade has not changed in the past two centuries. Even though the field of economics has broadened its scope and refined its theories since the time of Smith and Ricardo, economists’ opposition to trade restrictions is still based largely on the principle of comparative advantage.

In my view the potential economic loss of leaving the EU now is considerably less than the opportunity cost of not joining the EEC in 1973. 

In 1973 the EEC accounted for a much larger share of both world GDP and of the UK’s trade; tariffs on goods were generally much higher; goods formed a much larger part of trade, as “trade” in services was much less significant; and economic growth in the EEC was much higher than in the UK. All these factors have since changed.

The economic advantages of EU membership seem likely to continue to diminish. EU trade barriers on manufactured goods are now less than 4 per cent resulting in both the value of being in, and the cost of coming out, being less! As global GNP expands the EU share will continue to diminish and trade within the EU become relatively less important; services, where there is effectively no ‘common market’ in the EU will continue to expand and computer and internet technology further erode the significance of proximity in developing trade. Trade barriers are likely to continue to be reduced as global trade continues to expand.

All tariffs and trade restrictions inhibit trade and reduce economic growth and the EU seems unlikely to participate in any continuing reduction in tariffs but retains tariffs, significant non-tariff restrictions and regulations limiting free competition in services. In some industries, such as Agriculture and Horticulture, the EU is grossly protectionist.Indeed, the underlying antithesis to free trade is manifest in the ‘Brexit’ negotiations where tariffs, trade restrictions and non-tariff barriers are being widely and consistently deployed as bargaining chips to secure non-economic goals. In short, economic benefit is mediated to an extent by perceived political gain.

The difficulty in forecasting accurately the effect of the UK’s withdrawal from the EU quickly became evident as widespread gloomy forecasts for the economy subsequent to the referendum in 2016 such as theFT’sChief Economics Editor Martin Wolf’s forecast “it would be astonishing if there were to be no recession” proved wildly incorrect.

The errors of economic forecasts, especially at inflexion points are colourfully illustrated by many forecasts at the time of the Great Depression, starting in 1929. Particularly notable was that of Irving Fisher, the celebrated Yale economist, who on 17 October 1929, a week before the Wall Street crash, wrote in the New York Times: “Stock prices have reached what looks like a permanently high plateau. I do not feel there will be soon if ever a 50 or 60 point break from present levels, such as (bears) have predicted. I expect to see the stock market a good deal higher within a few months”, and on 14 November wrote, “The end of the decline of the Stock Market will probably not be long, only a few more days at most.” 

Fisher’s views were widely held: “We will not have any more crashes in our time” (JM Keynes 1927), “… despite its severity, we believe that the slump in stock prices will prove an intermediate movement and not the precursor of a business depression such as would entail prolonged further liquidation…” and “… a serious depression seems improbable; [we expect] recovery of business next spring, with further improvement in the fall.” (Harvard Economic Society, 2 and 10 November 1929); “Financial storm definitely passed” (Bernard Buruch to WS Churchill 15 November 1929) and “I am convinced that through these reasons we have re-established confidence” (President Hoover December 1929). 

Fisher’s forecast is reported as “the worst share tip in history”. The crisis broke on Thursday 24 October 1929, when the market dropped by 11 per cent. Black Thursday was followed by a 13 per cent fall on Black Monday and a further 12 per cent tumble on Black Tuesday. By early November, Fisher was ruined and the stock market was in a downward spiral ending only in “June 1932, at which point companies quoted in the New York Stock Exchange had lost 90 per cent of their value”.

The crash appeared “out of the blue,” but almost all subsequent analysis emphasises the inherent fragility of the late 1920s economy. A similar analysis of the recent “Great Depression” is encapsulated by HM The Queen’s question of Professor Luis Garicano of the LSE “If these things were so large, how come everyone missed them?”

The UK’s withdrawal from the EU is such a major turning point, albeit one foreseen. Making accurate forecasting is very difficult, a difficulty compounded by the overlay of political considerations – as the current negotiations now demonstrate.

Given the complexity, the multiplicity and the inconsistency of all the forecasts one conclusion is that no defensible position can be taken on the precise effect of Brexit by 2030!  Economic forecasting in the short-term is unreliable and over 12 years arguments over ± 0.25 percentage point differences in GNP seem surreal.  However, it is self-evident that the adjustment in the economy from the present EU membership to any new trading relationship cannot be made without upset and destruction in some areas, in some industries and to some people.  Almost without exception the long-term “costs” of leaving the EU are measured in real GNP, but the effect will be experienced largely in GNP per head, not total GNP and such a qualification would significantly reduce the forecast economic “cost”.

This article is an extract from Douglas Lowe’s Chairman's Statement for Caledonian Trust PLC December 2017. For the full statement please refer to Caledonian Trust PLC Interim Statement Half Year to 31 December 2017, here.

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